Microfinance Fever

A lot of people are chasing returns in barefoot banking. Here's what you should know before you follow.

Maria Guadalupe Licona, of Tulancingo, Mexico needed to expand her herd. So she borrowed $100 for six months from a microlender that charges on average 40% interest and purchased additional sheep and pigs.

The money came from somebody like J. Alex Hartzler. He and his partners sold their Web Clients ad business to online marketing firm
ValueClick
for $141 million in July 2005. A Fulbright scholar who volunteered in Bolivia with the Mennonite Church before entering law school, he wanted to put some of his gains into doing good.

So Hartzler, now 39, invested first in an equity fund and later in a debt fund managed by MicroVest of Bethesda, Md. and backed by a portfolio of notes taken out by mostly small Latin American borrowers. The debt fund's target ten-year return of 6%, net of fees, is only two percentage points better than the yield on default-proof ten-year Treasury notes. Without the do-good feel, it probably wouldn't attract much capital. Hartzler sticks one-fifth of his international holdings in microfinance and the rest in mainstream exchange-traded funds.

There are, of course, less adventurous ways to be a socially conscious investor. You could join the crowd selecting mutual funds that exclude naughty companies, such as those (depending on your taste) that make weapons, sell tobacco or run nuclear plants. The Social Investment Forum claims that socially conscious funds account for 10% of managed money, or $2.2 trillion.

Microfinance investing can be a little less passive than the average open-end fund. The idea gained attention when Muhammad Yunus won the 2006 Nobel Peace Prize. His Grameen Bank, founded three decades ago in Bangladesh, has $521 million outstanding on loans to small businesses in poor countries. High-profile microfinance investors include Ebay founder Pierre Omidyar and Sequoia Capital, the venture capital backer of
Google
and YouTube. An estimated 40 funds focused on microfinance have been created since 2005.

As many as half of the world's 3 billion poor may be eligible for microloans. Average loan sizes vary from $100 in India to $1,530 in Bolivia. The current $17 billion in loans outstanding represents 10% of the potential microfinance market, notes a 2006 McKinsey & Co. report.

Fixed-income microfinance funds return an average 5.8% in U.S. dollars, according to the Consultative Group to Assist the Poor, a group of 33 public and private development agencies. ProFund, the first private equity fund in microfinance, yielded an annualized 6.6% over ten years through 2005. Making loans directly to established microfinance institutions usually requires a minimum investment of $250,000 to $500,000. Depending on the fund, you can invest much less.

Not all these lenders are good ideas, though. "You need to discriminate between the 11,900 that aren't worth investing a dime in," cautions Michael Chu, a Harvard Business School professor and early investor in ProFund. Four Kampala microfinance firms are under Ugandan police investigation for cheating poor borrowers and refusing to fulfill withdrawal requests.

Many microfinance lenders function like banks. They pull in deposits from people in their communities. They rely on foreign investors for their risk capital, a mix of equity and subordinated debt.

The table lists the top ten of the better microfinance institutions. To assemble the list, we asked the Microfinance Information Exchange for financial results for 641 microfinance providers, and our list includes only those that reported audited financial statements. Also helpful were credit ratings from Sanjay Sinha, managing director of Micro-Credit Ratings International Ltd. in India, and Damian von Stauffenberg of MicroRate in Arlington, Va. Table standings reflect a consolidated score for four criteria (scale, efficiency, portfolio risk and profitability). For the full list, visit www.forbes.com/microfinance.

Top-ranked Asa (Bengali for hope) was founded as a civil rights organization in 1978 by a group of young people fighting a liberation struggle against Pakistan, but it didn't start issuing credit until 1991. A staff of 23,000 working at 3,300 branches across Bangladesh services loans, which average $110, to 5.5 million borrowers.

Crediamigo is the microfinance arm of Banco do Nordeste, a combination development, investment and commercial bank with 174 branches covering 1,955 cities in Brazil. It finances 77% of all the rural and industrial loans in the country's Northeast region. The Brazilian federal government controls 90% of Crediamigo shares with the remainder in private hands. Crediamigo caps loans at $1,400 and mostly pushes small loans lasting 3 to 18 months. These average $375 and come with a steep 35% interest rate.

With 537,000 borrowers and another 225,000 savers (as of December 2006), Amhara Credit & Savings Institution in Ethiopia is one of Africa's largest microfinanciers. On overhead it consumes only 5 cents of every net dollar lent (that's after interest costs are subtracted).

It keeps staff costs low and is frugal on such expenses as electricity. These microlending organizations have low default rates. The share of Amhara's loans in default or more than 30 days late on interest and principal payments, as of year-end 2006, was 1.5%.

Our top ten's overhead costs are low, ranging from 0.7% to 3.65% of gross national income per capita. They spend next to nothing on marketing and not much on paperwork. Our microfinance lenders show returns on assets that would be eye-popping for a commercial bank. Mexico's Banco Compartamos has a 23.2% ROA. How does it do that? Its loans cost on average a usurious-sounding 80% in interest. Also, its equity comes to 42.3% of assets, a much higher ratio than you'd see at any ordinary bank.

Here are ways do-gooders can join in:

MicroPlace.com, launched by Ebay this past October, is a regulated broker-dealer that sells microfinance loans online as securities through the Calvert Social Investment Foundation and Oikocredit USA. Most such securities mature in three years and yield 3%. You need as little as $100 to get in. The Web site has attracted $500,000 so far. The prospectus can be found on the site.

So-called microfinance investment vehicles typically either resell a basket of debts held by microfinance institutions or make equity investments in lenders directly. Minimum investments range from $100,000 to $500,000. One of the largest, MicroVest ($39 million in loans outstanding), is typical in that it raises money via private placements and is therefore not registered with securities regulators in states where it is offered. To gauge a fund manager, you should request a prospectus; they're usually not available on Web sites.

Downside: Expenses can be high, up to 2.5% of assets annually. Liquidity is as low as in a limited partnership or hedge fund: You have no right to withdraw before the announced close-down date (typically, in seven to ten years) and so would have to take your chances selling on the secondary market.

One other potential catch: If you invest in a microfinance fund incorporated offshore, you could get hit with a nasty "penalty tax" on "excess distributions" if the fund is liquidated and the right paperwork isn't done. (That's in addition to the normal tax on earnings from the investment, which might also drive up your tax accountant's bill.)

One way around this is practiced by Philip Smith of Tulsa, Okla., the former chief executive of Prize Energy, an oil and gas firm. He is investing in microfinance with dollars he's earmarked for charity anyway, using a donor-advised fund. Here, you donate cash, or better yet highly appreciated stock, to a fund and claim an income tax deduction now. Then you and your heirs dribble out contributions to favorite charities over the years.

Meanwhile, your charitable kitty is invested and (it's hoped) earning more for charity. Most community foundations, including ones in New York, Tulsa and Oakland, Calif., as well as religiously affiliated entities, allow donor-advised dollars to be invested in microfinance. So your dollars do good overseas, even as they earn a (modest) return for charity. And you avoid tax hassles. (Warning: Donor-advised funds affiliated with virtually all mutual fund companies, such as Vanguard and Fidelity, don't offer this option.)

Or you could buy shares in one of the handful of microlenders that are traded publicly. Alas, all but one are listed in such places as Indonesia and Kenya, where it's hard for foreigners to buy shares.